May 06, 2022
This article covers what an FBO is and some strategies you can use to capitalize on one if you're ever in need of one. It also covers some of the complexities surrounding the different types of FBOs.
FBO stands for “for the benefit of." It's a term used in finance to describe a transaction with both an income distribution and owner-benefits. In other words, it's the most favorable type of compound transaction under tax law. FBO transactions usually benefit from avoiding capital gains taxes while still benefiting from any long-term capital appreciation on investments.
Defined by the IRS as a contractual right or duty in which you are granted an interest in property that you do not own but have agreed to buy at a later date. Property typically includes stock, bonds, and real estate. "For example, if you are given the right to purchase a piece of real estate at a fixed price, such as a vacation home.
For example, if you are given the right to purchase a piece of real estate at a fixed price, such as a vacation home.
The beneficiary receives an interest in property that can be sold for more than its worth. The beneficiary owns no part of the property. Such properties include mutual funds and non-retirement IRAs. "You might have received stock in your mother's or grandmother's non-profit corporation that some people consider worthless and worth much more by others. If you are the beneficiary of a non-profit corporation, consider selling your interest before the death of your mother or grandmother because the increase in value might be taxed as income."
You receive income from an investment while you own it, so you can realize a gain on that investment by selling it at any time during the year. However, taxes on any realized gains will not be applied to income. Instead, they are deferred until the time you actually make a sale or exchange. After that time passes, tax on all realized gains will be applied at once as part of your standard tax return. This strategy is sometimes referred to as "deferring capital gains."
Note: The amount of taxes deferred can be substantial.
Part of your FBO transaction also involves transferring part of the ownership of that investment to another person or entity (the "beneficiary"). The most common arrangement is for the beneficiary to be a family member or friend. This arrangement allows for tax deferral on the investment because taxes on gains are not applied to income as long as you own the investment.
A will is one of the best ways to arrange an FBO transaction for most people. For example, if you have a child going through college, you could leave part of your 401K account to them with instructions to sell it after you die. This way, you get to keep receiving income from the investment while you're alive, and your child gets a good chunk of change when they need it most.
Be aware: that your beneficiaries will be required to report any capital gains as income when they sell the asset. This means it's essential that they use funds from the transaction right away (i.e., not let them sit in their investment portfolio). Otherwise, they could experience a pretty big tax bill when they sell the investment down the line.
The strategy that can take the most advantage in an FBO transaction is deferring capital gains. If you make income from investments and put the money in a taxable account, you'll pay taxes on it when you sell the investment, no matter how much more money it's worth. But if you put the money into an FBO, its income will be taxed later on as part of your normal tax return at a 25% federal rate. This means any gains you realize will also be taxed at a 25% rate instead of the higher capital gains tax rate that would otherwise apply. So if you're in a high enough tax bracket, you could be looking at significant savings by using an FBO.
Your investment accounts could be the beneficiaries of an FBO, but so could your family members or friends. For example, if your child is currently in college and stuck with hefty student loan payments, you can transfer part of your IRA to your child and instruct them not to sell it until they've finished repaying their student debt. You also get to avoid paying taxes on the income from the IRA as long as you own it. On top of that, your child doesn't pay taxes on any gains for as long as they hold onto the account (provided there are no other beneficiaries).
But care should be taken to make sure you choose the right strategy. FBOs are highly complex, and the rules can get very tricky depending on several factors, including:
What form of protection you have set up to protect beneficiaries from creditors if you become insolvent or die before repaying an estate debt.
Combining these factors can make for an overwhelming number of different possibilities.